The term "gamma squeeze" is used to describe the dynamic where an option contract’s price moves sharply in one direction due to changes in the underlying asset. This can happen when there is a sudden increase in demand for options contracts or if there is news that affects the asset’s price.

Gamma squeezes can be a profitable opportunity for options traders if they correctly predict the underlying asset’s price direction. However, prices can move rapidly, and predicting wrong can result in significant losses. 

Gamma squeeze vs. short squeeze

A gamma squeeze is associated with options positioning, while a short squeeze is related to stock positioning.

A short squeeze occurs when a heavily shorted stock’s price rises sharply, and the positioning of short sellers unwinds, causing further acceleration in the stock’s price. This can happen if unexpected news impacts the stock price or there is a sudden increase in demand for the stock.

A gamma squeeze occurs when there is an excessive amount of options buying in a single security that affects dealer hedging in a way that causes the underlying stock to move dramatically. 

Short squeeze example

To short a stock, a trader borrows shares from someone who owns them. The borrower then sells the shares and must return those shares in the future. In return, the share lender is paid interest from the borrower. 

When the borrowed shares are received, the borrower sells the stock almost immediately, and hopes to repurchase the stock at a lower price and return the shares to the original owner. 

The risk for the short seller is if the stock’s price rises. Because the short seller has to buy back the stock and return it to the lender, they may be forced to buy back shares at a higher price. 

Short sellers often use stop losses to manage risk. Stop losses are common for traders who are long and short stock. 

For example, if a trader has a bearish outlook on TSLA, they can borrow TSLA shares and sell them at $1,000 per share. If TSLA stock increases to $1,200 a share, their stop loss may trigger, and they will buy back the stock at a $200 loss per share. 

A short squeeze happens when a large percentage of a stock’s float is short. In other words, there are a lot of traders selling the stock short. If the stock price increases, the traders who sold the stock short have to “cover” their shorts and buy back the stock. 

This fuels more upward price momentum on the stock and results in a “short squeeze.”

Short squeezes can be profitable for traders who are long the stock, but they can also be dangerous because they can quickly turn into a gamma squeeze.

So, what's the difference between a gamma squeeze and a short squeeze?

A short squeeze happens because traders who shorted a stock are caught out of position. A gamma squeeze also occurs as a result of mispositioning. But with a gamma squeeze, the dealers have sold options, not stock.

Gamma squeeze example

A gamma squeeze occurs when there is a sudden increase in demand for an options contract. This increases the options' gamma. Gamma measures the rate of change of an option's price with respect to changes in the underlying asset.

A gamma squeeze is a result of dealer positioning. A gamma squeeze is similar to a short squeeze in that they both result in significant moves in the underlying stock. 

A classic example of a gamma squeeze occurred in 2008 when a sudden increase in demand for put options on Lehman Brothers stock created selling pressure.

As put buying increased, options dealers were forced to sell shares of Lehman stock to hedge their positions. The selling drove down the stock price, which exacerbated the gamma squeeze and caused Lehman’s shares to plummet. The dealers who sold the put options had to hedge their short put positions by selling more stock, further increasing volatility.

Another classic example of a gamma squeeze happened in early 2021 with Gamestop (GME). On January 25th, Gamestop’s stock increased 145% and was halted nine times due to excessive volatility.

Many attributed the move to a short squeeze. True, it was a short squeeze, but it was more than that. It was also a gamma squeeze. 

On January 28th, GME rose an additional 92% as members of the “Wall Street Bets” community piled into call options. On that day, traders bought roughly 1.5 million call options compared to just 178,000 put options.

As a result of the massive put/call skew, dealers who sold calls were forced to buy large quantities of GME stock to hedge their short gamma exposure. 

Gamma squeezes and dealer positioning

Dealer positioning refers to the position book of dealers and market makers. Dealers manage their options exposure by hedging with the underlying security. A dealer’s primary business is to make markets.

For example, when you buy a call, who sells you the option? Usually, it's a dealer. 

After making a market (bid-ask spread) and selling the call to a trader, the dealer is short delta and short gamma. If the stock rises, the dealer loses money. 

To hedge against the risk of a stock's price rising when positioned with a bearish short call, the dealer buys the underlying stock, neutralizing their delta and gamma exposure. 

The reverse is true if the option is a put instead of a call. If a trader buys a put, a dealer typically sells the put. This means the dealer is long or has positive delta and gamma exposure. If the stock begins to fall, the dealer loses money. To neutralize their positive gamma and delta exposure, they short the underlying stock. 

In the GME example, a short squeeze accelerated price higher. A large group of retail traders simultaneously bought call options in GME. 

The dealers who sold the calls were forced to buy stock to hedge the upward price movement in GME. More call buying led to more buying in the underlying stock by dealers. The cycle resulted in a massive move in GME’s price. 

Dealer positioning is important because it is one of the few things that we can attempt to quantify. 

We know that dealers want balanced risk exposure. If dealers make markets by taking the other side of a trade, they must also reflexively hedge that exposure. This creates a small but not insignificant insight into the positioning of a given underlying asset. 

How do you trade a gamma squeeze?

If you're an options trader, gamma squeezes can be an excellent opportunity for profit. But, it's important to understand how gamma squeezes work and the risks involved before trading.

Remember, a gamma squeeze can occur when a sharp increase in demand for options contracts occurs. This can result in rapid increases or decreases in the underlying price as dealers add hedges to their options exposure. 

To profit from a gamma squeeze, you need to be quick and have a reliable data source for dealer positioning.

Another metric to be aware of is the put/call ratio on a given underlying. As with GME, a gamma squeeze is more likely if the ratio is extreme. 

As soon as the squeeze starts, options prices begin to rise. Traders hope to buy options contracts before the price goes up too quickly. Then, they sell those contracts when the price increases.

It's also important to be aware of the risks involved in gamma squeezes. If the underlying stock price doesn't move as expected, options buyers hoping to profit from a gamma squeeze lose money. 

Unusual options activity, short interest, put/call ratios, and data on dealer positioning can offer insight into when a gamma squeeze might occur. Typically, the price action happens fast and unwinds equally as fast. So, it is essential to always have defined profit targets and defined stop losses in place.

Gamma squeezes can be a great way to profit as an options trader. But, you need to be aware of the risks involved.